Why Firms Disclose a Supplemental CEO-to-Median Worker Pay Ratio

Pay disparity between executives and employees has been criticized as evidence of corporate greed. It can also create perceptions of unfairness and dissatisfaction among employees, weakening their commitment and performance. To provide more information about pay disparity, the U.S. Congress enacted Section 953 (b) of Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which requires all publicly listed firms to disclose a Pay Ratio comparing annual CEO compensation with median annual employee compensation, excluding the CEO. Proponents of Section 953 (b) assert that the information helps investors understand and evaluate CEO compensation within a specific firm. However, critics argue that despite high preparation costs, Pay Ratio information unnecessarily confuses stakeholders in making voting or investment decisions.

The Final Rule of Section 953 (b) became effective on October 19, 2015 and applies to firms issuing annual reports since January 2018. The SEC has attempted to reduce preparation costs for firms by permitting both flexibility in calculating the Pay Ratio and issuance of a Supplementary Pay Ratio. For example, when calculating the main Pay Ratio, firms are permitted to choose the calculation date, exclude some employees, and use reasonable estimates for compensation. With respect to the Supplementary Pay Ratio, the SEC does not require a certain calculation method and demands only that firms provide appropriate explanations for the calculation. Our paper investigates whether this flexibility results in useful information for shareholders or merely in perception management.

We analyze the initial CEO-employee pay ratio data of 844 firms from the S&P 1500 Index that disclose the pay ratio in their proxy statements from January to June 2018. In our sample, 13 percent of firms provide a Supplementary Pay Ratio. Of the sub-sample of firms disclosing the Supplementary Pay Ratio, 15 percent provide supplementary ratios that are higher than the main Pay Ratio. We attempt to understand firms’ intentions in disclosing Supplementary Pay Ratios by analyzing the likelihood of a firm disclosing a Supplementary Pay Ratio, and particularly one higher than the main Pay Ratio.

Boards are responsible for the Pay Ratio disclosure and have two competing incentives. One is to disclose the true Pay Ratio, because firms can benefit from less information asymmetry between the firm and stakeholders on corporate pay practices. The other is to attempt to manage stakeholders’ perceptions by modifying the Pay Ratio. Boards have incentive to disclose a lower Pay Ratio to assuage stakeholder concerns over excessive CEO compensation. Supplementary Pay Ratios may provide firms an easy way to influence the stakeholders’ perceptions on executive compensation.

We find evidence consistent with both behaviors. Supporting the incentive to offer accurate information, firms with more geographical segments or a transitional CEO are more likely to provide a Pay Ratio. Supporting the incentive to act opportunistically, firms with greater excess CEO compensation and a higher-than-industry median Pay Ratio are more likely to disclose a Supplementary Pay Ratio.

In order to further distinguish between the informative incentive and the opportunistic incentive, we focus on a small minority of firms that provide a Supplementary Pay Ratio higher than the main Pay Ratio. This allows us to more precisely evaluate boards’ motives for disclosing a Supplementary Pay Ratio. We find that boards with stronger monitoring are more likely to disclose a Supplementary Pay Ratio higher than the Pay Ratio. Firms with higher proprietary costs and higher excess CEO pay are less likely to disclose a higher Supplementary Pay Ratio. When we compare firms that provide higher Supplementary Pay Ratios with firms that provide lower Supplementary Pay Ratios, we find that the former are larger, better-performing, less leveraged, and more unionized. Firms with upward adjustments also exhibit a main Pay Ratio lower than industry peers, less excess CEO pay, and more effective monitoring from the board and shareholders. Collectively, these findings suggest that firms’ decisions to disclose a Supplementary Pay Ratio higher than the Pay Ratio are driven by better monitoring and the incentive to truthfully disclose pay.

Our study contributes to the literature by shedding light on the debate surrounding the usefulness of the Pay Ratio disclosure. Our findings suggest that firms actively use discretion and supplemental disclosure permitted by the disclosure rules to help stakeholders assess pay disparity. At the same time, our evidence is also consistent with firms disclosing a lower Supplementary Pay Ratio in an attempt to manage stakeholders’ perceptions of pay disparity.

This post comes to us from Sun Moon Jung, Natalie Kyung Won Kim, and Han Seong Ryu, graduate students at Seoul National University, and from Professor Jae Yong Shin at Seoul National University. It is based on their recent paper, “Why Do Firms Disclose a Supplementary CEO-to-Median Worker Pay Ratio? Initial Evidence from Dodd Frank Act Section 953 (b),” available here.